UPS and using contracts to share the risk of building new capacity

Imagine you are service provider and you line up a bunch of extra capacity because your customers tell you that they are expecting they are really going to need you. What should you do when your customers turn out not to have that much business for you?

If you are UPS, you don’t have to imagine. This is a problem they face at the holidays. Retailers want to make sure that there will be space for their shipments on the truck, so they have an incentive to talk up their potential. Of course, no one can tell the future so sometimes their big talk will prove to be just hot air. UPS apparently is thinking of making the initial forecasts from retailer a little more binding (UPS Tries a New Twist on Surge Pricing, May 1, Wall Street Journal).

With the retail world in upheaval, UPS is asking retailers to help pay when the extra space and workers aren’t put to use—or even when the boxes don’t match the sizes that retailers promised earlier in the year.

“If there are variations to the plan, let’s see what we can do, but we should be compensated accordingly,” said UPS Chief Executive David Abney in an interview. He said the charge isn’t meant to be punitive but one element of a broader negotiation with retailers over pricing during peak times.

UPS is apparently also thinking of imposing charges at times beyond the holiday — say for flowers at Valentine’s or when a new product release causes volumes to spike.

I find this story really interesting — if only because it relates to a research stream I use to work in. One can model this problem as contracting in a newsvendor setting. UPS faces uncertain demand and needs to commit to a capacity before learning exactly what it is. And it essentially has one shot to get the number right. Yeah, the company may be able to scrounge up a few more college kids to shuffle packages or to have folks work overtime but all that is expensive. There is really just one chance to line up affordable capacity.

A newsvendor is a pretty straightforward problem but this one has a wrinkle. UPS has a forecast of demand and it may be able to refine that by working with the retailers. But the retailers will always be better informed about just what their needs are. UPS then needs a way to get retailers to credibly reveal their information.

Penalties are one way of doing this. UPS could offer a menu of contracts in which retailers must provide a forecast and choose a price-penalty pair. A low price per package would be paired with a high penalty while a high price per package would have little or no penalty. Mathematically, this would be very similar to UPS selling options on its capacity. If you pay a lot for the option of upfront, it costs little to execute the option and ship. If you buy an option with a low upfront price, execution becomes more expensive. Who takes which contract? If you are confident in your forecast, you opt for the higher penalty (or higher upfront option cost). You’re on the hook if things go poorly but if you are you have the right forecast, this would be the cheapest way of getting your demand served. Those who are just flat-out guessing, they pay a high price for service when they use it but avoid the downside if they don’t. UPS then goes into planning with better information. It not only has forecasts, it has further knowledge about which demand streams should be less variable.

Competition adds another twist. Consider a retailer that deals with both UPS and FedEx. Which shipper should they use for a particular package? Assuming that FedEx doesn’t impose penalties (according to the WSJ article, they are not planning on doing that right now), they should send it by UPS if they haven’t exhausted their commitments. They essentially have prepaid for the service, so they might as well use. On the flip side, UPS would have an incentive to favor firms who are paying high execution costs. If only one more box fits on the truck, it should be the one that is paying a lot.

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Professor Lariviere – an interesting wrinkle on this: UPS operations are so good that they can make decision about which parcel to leave off the truck (when only one more will fit) based on whether the customer has negotiated away their right to make a claim on service failures.

Another place you see this same type of demand/supply imbalance in logistics is in the truckload market at the end of the month (and it’s even more acute at the end of the quarter). At these times every manufacturer in North is ‘pushing freight’ off their dock into a truckload market that largely has fixed capacity. Transactional prices increase substantially – data shows 6-8% over the last two days of the month. As a manufacturer I’d be interested in holding freight on my dock (and missing my quarterly forecast once) to capture lower freight rates the rest of the month (and let my carriers sell their capacity into a high-demand market). I’ve discussed this with a lot of people that research or work in logistics and no one is aware of any shipper that is doing this type of demand balancing. The pain of missing the forecast for a public company may be too great but I would think a large privately-held firm would be interested in pursuing this strategy if they could find an appropriate way to contract the savings capture with their carriers.